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Successful strategies in trading often require doing what most people find distinctly uncomfortable.

-Jack Schwager

If you own shares of Archer Daniels Midlands (ADM), have you ever thought of following corn futures? What is the possible impact of a steep drop of the price of copper on the Phelps Dodge stock? It may be worth your effort to analyze such correlations.

Intermarket analysis can be a valuable tool when you trade individual or groups of stocks. This can be accomplished by comparing commodity-related stocks with the corresponding commodity or index. Since many stock groups have strong correlation with commodity markets, it also makes sense to analyze this relationship.

Some classic examples include the relationship between energy stocks and the price of crude oil, the correlation between gold miners and gold bullion or the impact of interest rate changes on financial stocks.

The systems presented in this chapter for trading oil and gold stocks are examples of using the correlation between a stock and a related commodity to develop a trading system.

15.1 TESTING METHOD

The correlation matrix between sector indices and related commodities is presented in Table 15.1. The best correlated commodity was used to construct an intermarket trading system based on the divergence of each stock from the corresponding commodity.